CHAPTERS 8 Utility and Demand. Marginal Utility Theory The purpose of marginal utility theory is to...

CHAPTERS 8Utility and Demand

Marginal Utility Theory

The purpose of marginal utility theory is to explain an individual household’s demand.

Marginal utility theory predicts that individual demand curves slope downward.

Therefore, market demand curves must also slope downward.

Household Consumption Choices

Two factors determine a household’s consumption choices: Its budget constraint (how much money

it has to spend and the prices of each good or service it buys)

Its preferences (how much it likes each good relative to others)

Budget Constraint

A household’s consumption choices are constrained by its income and by the prices of the goods and services it buys.

The limits to a household’s consumption choices are described by its budget constraint or sometimes called its budget line.

Example - Lisa’s Consumption Possibilities

Lisa has $30 per month to spend on movies and soda.

Movies cost $6 each. If she spends her entire budget on movies, she can see 5 per month.

Soda costs $3 per six-pack. If she spends her entire budget on soda, she can drink 10 six-packs a month.

Movies ($6) Soda ($3)

Expenditure Expenditure

Possibility Q (dollars) Q (dollars)

a 0 0 10 30

b 1 6 8 24

c 2 12 6 18

d 3 18 4 12

e 4 24 2 6

f 5 30 0 0

Consumption Possibilities


Movies (per month)

0 1 2 3 4 5

2

4

6

8

10S

oda

(six

-pac

ks

per

mon

th) a

b

c

d

e

f


Movies (per month)

0 1 2 3 4 5

2

4

6

8

10 a

b

c

d

e

f

Sod

a (s

ix-p

ack

s p

er m

onth

)

Each point on line exhausts the entire $30 budget

Affordable


Movies (per month)

0 1 2 3 4 5

2

4

6

8

10 a

b

c

d

e

f

Unaffordable

Sod

a (s

ix-p

ack

s p

er m

onth

)

Preferences

The combination of goods and services a person chooses to consume from the available choices on the budget line is determined by their likes and dislikes — their preferences.

The satisfaction a person gets from consumption is called utility.

Lisa’s Preferences

How Lisa spends her $30 per month depends on her preferences for movies and soda.

Each additional movie or soda she consumes increases her total utility.

Utility Is an Abstract Concept

We cannot directly observe values for utility.

However, each of us knows what we like and what we dislike.

We will consume more of the goods and services we like and less of those we dislike.

Total Utility

Total utility is the total benefit or satisfaction that a person gets from the consumption of goods and services.

Total utility depends on the level of consumption — more consumption generally increases total utility.

Lisa’s Total Utility

The more movies Lisa sees each month, the greater her total utility from movies.

The more soda Lisa drinks each month, the greater her total utility from soda.

Marginal Utility

Marginal utility is the change in total utility resulting from a one-unit increase in the quantity of a good consumed.

Total Utility and Marginal Utility

Quantity Total utility Marginal utility

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250

Movies

-



Movies

-50

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-5038

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-503833

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-50383329

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-5038332925

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-503833292521

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-50383329252118

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-5038332925211815

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-503833292521181512

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250



Movies

-503833292521181512 9

0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250

Diminishing Marginal Utility

As consumption of a good or service increases, the incremental (or marginal) satisfaction we get from consuming one more unit decreases.

This decrease is called the principle of diminishing marginal utility.


0 1 2 3 4 5

Un

its

of u

tilit

y 50 50

100

150

200

0 1 2 3 4 5Quantity (movies per month)

Un

its

of u

tilit

y

Quantity (movies per month)

0 1 2 3 4 5

50 50

100

150

200


Un

its

of u

tilit

y

Totalutility



Un

its

of u

tilit

y

50

0 1 2 3 4 5

50 50

100

150

200


Un

its

of u

tilit

y

Increasingtotal utility...

Totalutility



Un

its

of u

tilit

y

3850

0 1 2 3 4 5

50

…and diminishingmarginal utility

50

100

150

200


Un

its

of u

tilit

y


Totalutility



Un

its

of u

tilit

y

333850

0 1 2 3 4 5

50


50

100

150

200


Un

its

of u

tilit

y


Totalutility



Un

its

of u

tilit

y

29333850

0 1 2 3 4 5

50


50

100

150

200


Un

its

of u

tilit

y


Totalutility



Un

its

of u

tilit

y

2529333850

0 1 2 3 4 5

50


50

100

150

200


Un

its

of u

tilit

y


Totalutility



Un

its

of u

tilit

y

2529333850

0 1 2 3 4 5

50


Marginalutility

50

100

150

200


Un

its

of u

tilit

y


Totalutility



Un

its

of u

tilit

y



Soda

- 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-75

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-7542

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-754236

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-75423628

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-7542362825

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-754236282519

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-75423628251918

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-7542362825191817

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-754236282519181716

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291



Soda

-75423628251918171615

0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291

Maximizing Utility

A household’s income and the prices it faces limit the total utility it can obtain.

We assume that households consume the quantities of goods and services that maximize total utility.

People must make hard choices because wants exceed resources.

The Utility-maximizing Choice

A consumer equilibrium is a situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.

Lisa's Affordable Combinations

Movies Soda Total utility

Quantity from movies Six-packsper month Total utility and soda Total utility per month

a 0 0 291 10

b 1 50 260 8

c 2 88 225 6

d 3 121 181 4

e 4 150 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 260 8

c 2 88 225 6

d 3 121 181 4

e 4 150 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 310 260 8

c 2 88 225 6

d 3 121 181 4

e 4 150 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 310 260 8

c 2 88 313 225 6

d 3 121 181 4

e 4 150 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 310 260 8

c 2 88 313 225 6

d 3 121 302 181 4

e 4 150 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 310 260 8

c 2 88 313 225 6

d 3 121 302 181 4

e 4 150 267 117 2

f 5 175 0 0




a 0 0 291 291 10

b 1 50 310 260 8

c 2 88 313 225 6

d 3 121 302 181 4

e 4 150 267 117 2

f 5 175 175 0 0

Equalizing Marginal Utility Per Dollar Spent

The allocation that maximizes total utility will also make the marginal utility per dollar spent on each good equal for all goods.

The marginal utility per dollar spent is the marginal utility obtained from the last unit of a good consumed divided by the price of the good.

Maximizing Total Utility

Total utility is maximized when all the consumer’s income is spent and when the marginal utility per dollar spent is equal for all goods.

If all income is not spent, utility could be improved by spending more. Therefore, the consumer will spend all income.

Lisa Maximizes Utility

She spends all her income and

MUmovies/ Pmovies = MUsoda/ Psoda

Equivalently:

MUmovies/MUsoda = Pmovies/ Psoda

Equalizing Marginal Utilities Per Dollar Spent

a 0 0 - 10 15

b 1 50 8 17

c 2 38 6 19

d 3 33 4 28

e 4 29 2 42

f 5 25 0 0 -

Movies ($6 each) Soda ($3 per six-pack)

Marginal Marginal utility utility

Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent


a 0 0 - 10 15

b 1 50 8.33 8 17

c 2 38 6 19

d 3 33 4 28

e 4 29 2 42

f 5 25 0 0 -





a 0 0 - 10 15

b 1 50 8.33 8 17

c 2 38 6.33 6 19

d 3 33 4 28

e 4 29 2 42

f 5 25 0 0 -




Equalizing Marginal Utilities per Dollar Spent

a 0 0 - 10 15

b 1 50 8.33 8 17

c 2 38 6.33 6 19

d 3 33 5.50 4 28

e 4 29 2 42

f 5 25 0 0 -





a 0 0 - 10 15

b 1 50 8.33 8 17

c 2 38 6.33 6 19

d 3 33 5.50 4 28

e 4 29 4.83 2 42

f 5 25 0 0 -





a 0 0 - 10 15

b 1 50 8.33 8 17

c 2 38 6.33 6 19

d 3 33 5.50 4 28

e 4 29 4.83 2 42

f 5 25 4.17 0 0 -





a 0 0 - 10 15 5.00

b 1 50 8.33 8 17

c 2 38 6.33 6 19

d 3 33 5.50 4 28

e 4 29 4.83 2 42

f 5 25 4.17 0 0 -





a 0 0 - 10 15 5.00

b 1 50 8.33 8 17 5.67

c 2 38 6.33 6 19

d 3 33 5.50 4 28

e 4 29 4.83 2 42

f 5 25 4.17 0 0 -





a 0 0 - 10 15 5.00

b 1 50 8.33 8 17 5.67

c 2 38 6.33 6 19 6.33

d 3 33 5.50 4 28

e 4 29 4.83 2 42

f 5 25 4.17 0 0 -





a 0 0 - 10 15 5.00

b 1 50 8.33 8 17 5.67

c 2 38 6.33 6 19 6.33

d 3 33 5.50 4 28 9.33

e 4 29 4.83 2 42

f 5 25 4.17 0 0 -





a 0 0 - 10 15 5.00

b 1 50 8.33 8 17 5.67

c 2 38 6.33 6 19 6.33

d 3 33 5.50 4 28 9.33

e 4 29 4.83 2 42 14.00

f 5 25 4.17 0 0 -




Lisa Maximizes Utility She spends all her income and

MUmovies/ Pmovies = MUsoda/ Psoda

(38/6) = (19/3)

= 6.33 Equivalently:

MUmovies/MUsoda = Pmovies/ Psoda

(38/19) = (6/3)

= 2

Why the Marginal Utility Rule Maximizes Total Utility

Case I If the ratio of marginal utility to price

is higher for movies than for soda, Lisa can increase total utility by consuming less soda and more movies.

If MUmovies/ Pmovies > MUsoda/ Psoda then the next movie provides more satisfaction per dollar than a soda.

Why the Marginal Utility Rule Maximizes Total Utility

Case II If the ratio of marginal utility to price

is lower for movies than for soda, Lisa can increase total utility by consuming more soda and less movies.

If MUmovies/ Pmovies < MUsoda/ Psoda then the next soda provides more satisfaction per dollar than a movie.


Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

4.00

8.33

12.00

16.00

6.335.67

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)


Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

4.00

8.33

12.00

16.00

6.335.67

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)

MUm

Pm


Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

4.00

8.33

12.00

16.00

6.335.67

MUs

Ps

MUm

Pm

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)


Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

4.00

8.33

12.00

16.00

6.335.67

MUs

Ps

MUm

Pm

Maximumtotal utility

Case IIUtility gainfrom moresoda and fewer movies

Case IUtility gainfrom moremovies and less soda

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)

Consuming Only Sodas

Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

MUs

Ps

MUm

Pm

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)

Consuming Only Movies

Movies

SodaPossibility

0 1 2 3 4 510 8 6 4 2 0a b c d e f

MUs

Ps

MUm

Pm

Mar

gina

l uti

lity

per

dol

lar

spen

t(u

nits

of

uti

lity

per

dol

lar)

The Power ofMarginal Analysis

The method we have used to maximize Lisa’s utility is an example of marginal analysis.

By comparing marginal gain with marginal loss, we can guarantee that total utility is maximized.

New Ways of Explaining Consumer Choices

Behavioral EconomicsBehavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influence economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.There are three impediments to rational choice:

Bounded rationality

Bounded willpower

Bounded self-interest


Bounded RationalityBounded rationality is rationality that is limited by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.


Bounded WillpowerBounded will-power is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.


Bounded Self-InterestBounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others. Main applications are in finance where uncertainty is the key factor and savings where future is the key factor.


One behavior observed by behavioral economists is more general and might affect your choices.The Endowment Effect

The endowment effect is the tendency for people to value something more highly simply because they own it.


NeuroeconomicsNeuroeconomics is the study of the activity of the human brain when a person makes an economic decision.Different decisions appear to activate different areas of the brain. Some decisions are made

In the pre-frontal cortex where memories are stored and data analyzed and where decisions might be deemed rational.

In the hippocampus where memories of anxiety and fear are stored and where decisions might be deemed irrational.


ControversyShould economics focus on explaining the decisions we observe or should it focus on what goes on inside people’s heads?This is the controversy.For most economists, the goal of economics is to explain the decisions that we observe people make, and not to explain what goes on inside people’s heads.

CHAPTERS 8 Utility and Demand. Marginal Utility Theory The purpose of marginal utility theory is to...

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